Currency Wars (and more…)

QE Forever

This article explains in greater detail a subject I addressed in a recent comment in the Wall St. Journal:

“…our macroeconomic models are wholly incapable of incorporating operational measures of uncertainty and risk as variables that affect human decision-making under loss aversion. We’ve created this unmeasurable sense of uncertainty by allowing exchange rates to float, leading to price volatility in asset markets because credit policy is unrestrained.

The idea of floating exchange rates was that currency markets would discipline fiscal policy across trading partners. But exchange rates don’t directly signal domestic voters in favor of policy reform and instead permit fiscal irresponsibility to flourish. Lax credit policy merely accommodates this fiscal fecklessness. The euro and ECB were tasked with reining in fiscal policy in the EU, but that has also failed with the fudging of budget deficits and the lack of a fiscal federalism mechanism.

The bottom line is that we do NOT have a rebalancing mechanism for the global economy beyond the historic business cycles of frequent corrections that are politically painful. The danger is we now may be amplifying those cycles.”

From Barron’s:

Currency Wars: Central Banks Play a Dangerous Game

As nations race to reduce the value of their money, the global economy takes a hit.”

Feb. 13, 2015
It’s the central banks’ world, and we’re just living in it. Never in history have their monetary machinations so dominated financial markets and economies. And as in Star Trek, they have gone boldly where no central banks have gone before—pushing interest rates below zero, once thought to be a practical impossibility.At the same time, central bankers have resumed their use of a tactic from an earlier, more primitive time that was supposed to be eschewed in this more enlightened age—currency wars.
The signal accomplishment of these policies can be encapsulated in this one result: The U.S. stock market reached a record high last week. That would be unremarkable if central bankers had created true prosperity.
But, according to the estimate of one major bank, the world’s economy will shrink in 2015, in the biggest contraction since 2009, during the aftermath of the financial crisis. That is, if it’s measured in current dollars, not after adjusting for inflation, which the central bankers have been trying desperately to create, and have failed to accomplish thus far.
Not since the 1930s have central banks of countries around the globe so actively, and desperately, tried to stimulate their domestic economies. Confronted by a lack of domestic demand, which has been constrained by a massive debt load taken on during the boom times, they instead have sought to grab a bigger slice of the global economic pie.Unfortunately, not everybody can gain a larger share of a whole that isn’t growing—or may even be shrinking. That was the lesson of the “beggar thy neighbor” policies of the Great Depression, which mainly served to export deflation and contraction across borders. For that reason, such policies were forsworn in the post–World War II order, which aimed for stable exchange rates to prevent competitive devaluations.

Almost three generations after the Great Depression, that lesson has been unlearned. In the years leading up to the Depression, and even after the contraction began, the Victorian and Edwardian propriety of the gold standard was maintained until the painful steps needed to deflate wages and prices to maintain exchange rates became politically untenable, as the eminent economic historian Barry Eichengreen of the University of California, Berkeley, has written. The countries that were the earliest to throw off what he dubbed “golden fetters” recovered the fastest, starting with Britain, which terminated sterling’s link to gold in 1931.

This, however, is the lesson being relearned. The last vestiges of fixed exchange rates died when the Nixon administration ended the dollar’s convertibility into gold at $35 an ounce in August 1971. Since then, the world has essentially had floating exchange rates. That means they have risen and fallen like a floating dock with the tides. But unlike tides that are determined by nature, the rise and fall of currencies has been driven largely by human policy makers.

Central banks have used flexible exchange rates, rather than more politically problematic structural, supply-side reforms, as the expedient means to stimulate their debt-burdened economies. In an insightful report last week, Morgan Stanley global strategists Manoj Pradhan, Chetan Ahya, and Patryk Drozdzik counted 12 central banks around the globe that recently eased policy, including the European Central Bank and its counterparts in Switzerland, Denmark, Canada, Australia, Russia, India, and Singapore. These were joined by Sweden after the note went to press.

In total, there have been some 514 monetary easing moves by central banks over the past three years, by Evercore ISI’s count. And that easy money has been supporting global stock markets (more of which later).

As for the real economy, the Morgan Stanley analysts write that while currency devaluation is a zero-sum game in a world that isn’t growing, the early movers are the biggest beneficiaries at the expense of the late movers.

The U.S. was the first mover with the Federal Reserve’s quantitative-easing program. Indeed, it was the initiation of QE2 in 2010 that provoked Brazil’s finance minister to make the first accusation that the U.S. was starting a currency war by driving down the value of the dollar—and by necessary extension, driving up exchange rates of other currencies, such as the real, thus hurting the competitiveness of export-dependent economies, such as Brazil.

Since then, the Morgan Stanley team continues, there has been a torrent of easings (as tallied by Evercore ISI) to pass the proverbial hot potato by exporting deflation. That has left just two importers of deflation—the U.S. and China.

The Fed ended QE last year and, according to conventional wisdom, is set to raise its federal-funds target from nearly nil (0% to 0.25%) some time this year. That has sent the dollar sharply higher, resulting in imported deflation. U.S. import prices plunged 2.8% in January, albeit largely because of petroleum. But over the past 12 months, overall import prices slid 8%, with nonpetroleum imports down 1.2%.

China is the other importer of deflation, they continue, owing to the renminbi’s relatively tight peg to the dollar. The RMB’s appreciation has been among the highest since 2005 and since the second quarter of last year. As a result, China has lagged the Bank of Japan, the ECB, and much of the developed and emerging-market economies in using currency depreciation to ease domestic deflation.

The bad news, according to the Morgan Stanley trio, is that not everyone can depreciate their currency at once. “Of particular concern is China, which has done less than others and hence stands to import deflation exactly when it doesn’t need to add to domestic deflationary pressures,” they write.

But they see central bankers around the globe being “fully engaged” in the battle against “lowflation,” generating monetary expansion at home and ultralow or even negative interest rates to generate growth.

The question is: When? Bank of America Merrill Lynch global economists Ethan Harris and Gustavo Reis estimate that global gross domestic product will shrink this year by some $2.3 trillion, which is a result of the dollar’s rise. To put that into perspective, they write, that’s equivalent to an economy somewhere between the size of Brazil’s and the United Kingdom’s having disappeared.

Real growth will actually increase to 3.5% in 2015 from 3.3% in 2014, the BofA ML economists project; but the nominal total will decline in terms of higher-valued dollars. The rub is that we live in a nominal world, with debts and expenses fixed in nominal terms. So, the world needs nominal dollars to meet these nominal obligations.

A drop in global nominal GDP is quite unusual by historical standards, they continue. Only the U.S. and emerging Asia are forecast to see growth in nominal-dollar terms.

The BofA ML economists also don’t expect China to devalue meaningfully, although that poses a major “tail” risk (that is, at the thin ends of the normal, bell-shaped distribution of possible outcomes). But, with China importing deflation, as the Morgan Stanley team notes, the chance remains that the country could join in the currency wars that it has thus far avoided.

WHILE ALL OF THE central bank efforts at lowering currencies and exchange rates won’t likely increase the world economy in dollar terms this year, they have been successful in boosting asset prices. The Standard & Poor’s 500 headed into the three-day Presidents’ Day holiday weekend at a record 2096.99, finally topping the high set just before the turn of the year.

The Wilshire 5000, the broadest measure of the U.S. stock market, surpassed its previous mark on Thursday and also ended at a record on Friday. By Wilshire Associates’ reckoning, the Wilshire 5000 has added some $8 trillion in value since the Fed announced plans for QE3 on Sept. 12, 2012. And since Aug. 26, 2010, when plans for QE2 were revealed, the index has doubled, an increase of $12.8 trillion in the value of U.S. stocks.

The Swiss Bail

Swiss-National-Bank-Chappatte_200115

This is a good, succinct explanation of the significance of the Swiss National Bank action to cease printing money and what’s in store for the central bank policies of the world.

Quote from asset manager Axel Merk:

Ultimately, central banks are just sipping from a straw in the ocean. I did not invent that term. Our senior economic advisor, Bill Poole, who is the former president of the St. Louis Federal Reserve taught us this: that central banks are effective as long as there is credibility.

What central banks have done is to try to make risky assets appear less risky, so that investors are encouraged or coerced into taking more risks. Because you get no interest or you are penalized for holding cash, you’ve got to go out and buy risky assets. You’ve got to go out and buy junk bonds. You have to go out and go out and buy equities.

The equity market volatility, until not long ago, has been very low. When volatility is low, investors are encouraged to buy something that is historically risky because it is no longer risky, right?

But as the Swiss National Bank has shown, risk can come back with a vengeance. The same thing can happen of course, in any other market. If the Federal Reserve wants to pursue an “exit” to its intervention, if it wants to go down this path, well, volatility is going to come back.

Everything else equal, it means asset prices have to be priced lower. That is the problem if you base an economic recovery exclusively on asset price inflation. We are going to have our hands full trying to kind of move on from here. In that context, what the Swiss National Bank has done is it is just a canary in the coal mine that there will be more trouble ahead.

The Sinister Evolution Of Our Modern Banking System

Fed

Repost from Peak Prosperity blog. (Link to podcast and blog here.)

Because we’re all about those banks, ’bout those banks…
Saturday, January 31, 2015

I quit Wall Street and decided that it was time to talk more about what was going on inside it, as it had changed. It had become far more sinister and far more dangerous. ~ Nomi Prins

Today, the ‘revolving door’ connecting our political and financial systems is evident to anyone with eyes. But this entwined relationship between Washington DC and Wall Street is nothing new, predating even the formation of the Federal Reserve.

To chronicle the evolution to where we find ourselves today, we welcome Nomi Prins, Wall Street veteran turned financial industry reformist, and author of the excellent expose All The Presidents Bankers.

In this well-detailed interview, Nomi goes into depth of the rationale and process behind the creation of the Federal Reserve, and more important, how its mandate — and the behavior of the banking system overall — metastasized into the every-banker-for-himself regime of sanctioned theft we now live with.

Chris Martenson:   To me, it couldn’t have been more obviously obscene then in 2010, and I believe maybe 2009, right after the big banks had been handed just vast, huge, very favorable handouts and bailouts during the Great Recession — and then they handed themselves record bonuses. I thought optically that was just horrible. As somebody who was inside the banking system: Are they that tone deaf? What’s behind that sort of behavior?

Nomi Prins:   Indeed, they have become very isolated.

It began with the period before the 1970s when different people were rising to leadership in banks, and worsened in the 80s when we started seeing people who had more sociopathic tendencies or less ability to appreciate the idea of the public’s economic stability being beneficial to growing their institutions. They no longer viewed it as necessary.

And with the advent of the larger futures market, the options market, the derivatives market, and all the off-shore elements of banking that were able to be developed, so much capital was now available and off of the books that the idea of maintaining some sort of a connection to stability policy — or even to whatever the Presidency might want — dissolved. At the same time, all the Presidents that were involved in running the country around that time didn’t ask or require accountability towards financial stability from them.

So there was a bunch of things that were happening at the same time, and that’s why the media does a poor job of critiquing this because they’re not looking at all the strands. None of this is simple. A lot of things happened at the same time to create these kinds of shifts. On the one hand, you have no restraint: you don’t have the Gold Standard anymore, so you have less of a strain on having something physical be reserved against your leverage. You now have this ability of petrodollars being recycled. You have the ability to leverage more debt. You have less humility. You have a more technologically-advanced, less transparent global financial system, so you can make and hide money easier. And then you have ascendancies of leadership in banks and in the government that are OK with all this, and allow it to fester.

It’s all defended as some sort of example of a free market and competition — “the best gets the best”, and so forth — when the reality is it just destabilizes the entire system and creates an artificiality. We see central banks supporting all of this mess, as opposed to figuring out what the exit policy is — which none of them have a clue about. That’s really where we’ve evolved to.

Listen to the entire podcast.

Rethinking Inequality and Redistribution in a Free Society

taxtherich

Inequality has become a hot political topic these days and may be most contentious issue of the 2016 presidential election (unless a geopolitical crisis occurs before then). The study of economic inequality and what to do about it has a long history though, and not much has changed.

In this post I would like to suggest some different ways of looking at the problem and what to do about it from a policy perspective. Many people look at the distributional outcomes of success in a winner-take-all society and declaim the results as unfair. It probably is unfair, just like it is when all the tallest kids get chosen to play on the basketball team. But, more seriously, fairness is not an objective measure by which we can set policy.

Most people think they can define what’s fair and what’s not. I would tend to agree, but mine probably departs from the common sense definition. When looking at results in life, one person’s fairness (the winners’ bracket) is another’s unfairness (the losers’ bracket). So, should fairness be determined by who has the most political power and influence in society, even if that is a tyranny of the majority? I fail to see how that would be fair.

Fairness can actually be defined by the legal idea that consequence should follow action. In other words, the guilty, not the innocent, should pay for their sins. In finance, this idea of fairness is couched in the concept of risk and reward: he who takes the risk, reaps the reward (or the loss).

The question is how do we apply this objective idea of fairness (I would prefer the word “justice”) to policies to mitigate unequal outcomes? Or even should we?

I will argue that we should, but that we’re devising all the wrong policies because we are trapped in a conceptual maze. Economic inequality is truly a maze of confusion. There are many different factors that lead to unequal results and it’s quite easy and common to focus on the wrong ones. The factors that have become politically salient today are related to the diverging returns between capital and labor. This is at the root of all the hullabaloo over French economist Thomas Piketty’s work, a work that has been politicized to confirm the worse fears of labor advocates.

In short, globalization and technology has led to wage repression for the 99%, while increasing the returns to capital (the 1%). The keen-jerk solution is to tax capital after the fact and redistribute the funds to labor. The POTUS stated this proposal explicitly in his recent SOTU address: “Let’s close the loopholes that lead to inequality by allowing the top 1 percent to avoid paying taxes on their accumulated wealth.” In effect, he was advocating for tax reform, but he failed to specify details. But we have a good idea on what kind of economic policies Mr. Obama favors: free community college tuition, minimum wage laws, family childcare and education credits, paid sick leave. One can argue the pros and cons of these policies, but none of them really addresses the growing problem of inequality. My guess is that is because the administration really doesn’t have any new ideas about what to do about inequality except to wave it as a red flag during election season.

There is a serious problem with trying to tax capital to redistribute to labor that I would like to present here in the simplest of terms. Capital has dominant strategies to win any conflict with labor in a free society. If we tax capital, it can instantly move elsewhere to avoid the tax. Financial capital is fungible, it can change it’s use. Or it can lie dormant in the bank vault or a mattress. Labor enjoys none of these advantages: we can’t easily get up and move, we are specialized by skills and education, and we can’t be idle for long because we have to eat. In a class war between capital and labor, labor must capitulate, at least in a free society.

The political measures that seek to prevent this – such as repatriation laws, tax penalties, capital controls, crackdowns on tax havens and accounting rules – are largely ineffective because capital enjoys these freedoms that are partly incumbent to its nature. Eliminating capital mobility would require the complete coordination of the international community, which implies state control over the deployment of capital. This would be contradictory to a free society, as much as the complete state control of labor mobility would. In other words, state coercion is incompatible with a free society and thus any tax costs will fall mostly on labor. This is not the result we want.

So, are we stuck in an impossible situation where those who own and control capital dominate those who don’t? I don’t believe so, but the solutions lie outside the present constellation of policies.

The first lesson is that if capital dominates the distribution of returns, then success in capitalism requires access, ownership, and control of capital.  Simply put, in a capitalist society, why aren’t we all clamoring to become capitalists? (You don’t have to run a business to be a capitalist, you just need to buy into public corporate share ownership and control.)

The next objection is that capital ownership and control cannot be pried from the hands of the rich and powerful without coercion by a democratically-elected government. In other words, we’re back to tax coercion. It is certainly true that we can tax physical capital and wealth through property and estate taxes. A mansion cannot be moved or disappear because it is taxed and the tax cannot be avoided by selling the property since the sales price will instantly reflect the tax liability. Wealth taxes are probably necessary due to the massive transfer of wealth under the misguided policies of the past two decades, but we’re missing the larger point if we focus solely on this redistribution of wealth after the fact. (My proposal for estate taxes is that they could be avoided entirely if the estate distributed the capital in limited amounts voluntarily according to the wishes of the principal. This happens to a certain extent with charitable gifts, but I would broaden the idea to cover any beneficiaries.)

However, beyond wealth taxes, there IS a way to incentivize someone to surrender at least some of their capital voluntarily. In fact, we all do it all the time when we buy insurance. By paying insurance premiums we surrender capital wealth in order to reduce risk and preserve the remainder. The rich have long practiced capital preservation strategies to protect their wealth. So risk is exchanged with capital.

This is also how Wall Street bankers get rich – they assume risk, manage it successfully, and then reap the rewards. So, if those without capital assume the equity risks going forward, and their property rights are vigorously defended, they can reap the rewards of economic success through their labor and their capital accumulation. The rich willingly give up some of their control in return for reducing their risks. As a society we can redistribute wealth by redistributing and managing risk.

This happens now when we save and invest in new business ventures, or accumulate a portfolio of financial assets such as stocks and bonds. But to really make a dent in inequality we must broaden and deepen capital ownership with a range of policy reforms that consistently reward working, saving, investing, accumulating capital, and diversifying risk. In a free society the government was never meant to do all of this for us, especially when we can do it better ourselves. I also would not expect most politicians in Washington to someday wake up and discover these reforms by themselves.

 

 

 

 

Banking Vegas-Style: Casino or Golf?

Banking2

Banking has a long, colorful history – in fact, it’s probably the world’s second oldest profession and created as much controversy as the first. Banking in modern times was largely a sedate affair, characterized by what is known as the 3-6-3 rule: pay 3% on savings deposits, lend at 6%, and be on the golf course for a 3 pm tee time. But more recently banking has undergone a radical transformation, one that viciously came to light during the 2008 global financial crisis.

This transformation can be noted in the explosive growth of two asset markets: foreign currency exchange (FOREX) and the markets for financial derivatives. Let us consider first some of the changing metrics of the foreign currency exchange market (source: Wikipedia):

The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The FOREX market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global FOREX and related markets is continuously growing. According to the Bank for International Settlements,[4] the preliminary global results from the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in FOREX markets averaged $5.3 trillion per day in April 2013.

Compare this to the total value of global trade in real goods and services for the entire year of 2013, which was only $37.7 trillion. Obviously, there’s a lot of action in foreign currency trading. Why? Because of the volatility of floating currency rates. The original idea of moving from fixed exchange rates to floating rates was that policy differences between countries would be forced to converge on efficient fiscal and monetary policies because of the discipline imposed by currency fluctuations. In other words, bad policies would harm the domestic economy and the markets would sell off the domestic currency, forcing politicians to correct those policies.

Unfortunately, the opposite happened. Bad economic policies caused currency values to fluctuate widely, creating price volatility that attracted the attention of traders into the game, creating the exponential increase in trading volumes (with the economic consequences). And guess who are the major traders of foreign currencies, otherwise called speculators? You guessed it: the major global banks that today are Too Big To Fail.

The volatility of FOREX markets then created the opportunity for financial innovation to create numerous new markets for those wonderful financial derivatives we’ve all heard so much about. To give an idea of the size of the derivatives market, The Economist magazine has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion.

Don’t misunderstand this – financial derivatives have been around for a long time to hedge the uncertainty of price changes over time. In other words, they can provide insurance against the risk of loss associated with those price changes. This is what commodity futures are about, where farmers can lock in a price for their products, be it corn or pork bellies, before they invest in new production. There is a productive financial role for derivatives, which is why they exist. However, newly created volatility in asset markets can be highly leveraged in derivatives markets (think 100 to 1), to offer gambles with incredible pay-offs. Often this just becomes a highly leveraged play on risk with OPM (Other Peoples’ Money) yielding little economic benefit. In other words, a casino.

The problem is that gambles don’t always pay-off and somebody gets saddled with the losses. As these markets have grown, national governments have had to become heavily involved in assuring the integrity of these markets. Consequently they have been forced into the breach to backstop the losses with bailouts that eventually fall on taxpayers – either in the form of accumulated debt and increased taxes, but also through the slow devaluation of the currency. This helps reduce the value of debts incurred by speculators in the FOREX and derivative casinos.

The upshot is that banking is no longer a boring but secure backwater for the country club crowd. It’s become a hot-bed of furious trading and living on the edge, with incredible pay-offs to the winners and taxpayer bailouts for the losers. We’ve essentially turned finance, which is supposed to fund the real economy with prudent capital investment, into a trading casino where winners and losers result from the throw of the dice.

WallStreetCasino1

How do we sober up? That’s a good question that we’re going to have to ponder at some point. It certainly would be nice to send the bankers back out on the golf course. Hopefully before the next global financial crisis wipes us out.

This Wild Market

stock-market-the-ride

This Wild Market

Perhaps we can figure out what’s going on in the markets today if we read between the lines.  Prof. Shiller explains that “…the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. Which means that CAPE today is largely a reflection of the Greater Fool Theory of investment.

Then Mr. Shiller states that “[t]oday’s level “might be high relative to history, but how do we know that history hasn’t changed?”

I would guess that history has changed. Starting when the dollar and all other currencies became free floating in 1971, empowering central banks to create credit at will according to political dictates. This credit creation has occurred simultaneously with the expansion of the global labor supply in concert with new technology, both of which have depressed inflationary price signals, permitting central banks to continue their credit expansion at little apparent cost. It’s all good, as the shadow bankers might say.

But the less obvious result has been volatility of asset prices that we see reflected in the 30 year transition of financial markets toward trading away from new productive capital investment. This is how the hedge fund industry has blossomed.

The value of financial assets has departed from cash flow fundamentals and the result is markets that pop one day and deflate the next, depending on the sentiment of the moment, rather than underlying economic fundamentals. We’ve created greater price uncertainty in the economy that hampers productive long-term investment and concentrates the rewards in a shrinking cohort of lucky asset holders. This violates the most basic theory of financial management under uncertainty, which is stability through diversification.

This history was not inevitable, it was deliberately pursued under faulty intellectual models of our market society.

From the WSJ’s MoneyBeat:

Robert Shiller on What to Watch in This Wild Market

By Jason Zweig

You would have to be crazy to think the stock market isn’t crazy.

In three tumultuous days this week, the Dow Jones Industrial Average dived 273 points, then jumped up 275 points, then dropped 335 points.

But you might be even crazier if you think you know exactly when to get out of the market.

Few people understand that better than Robert Shiller, the Yale University finance professor who shared the Nobel Prize in economics last year for his research documenting that stock prices fluctuate far more than logic can justify—and who is renowned for telling people when to get out of the market.

Prof. Shiller predicted the collapse of both the technology-stock bubble in 2000 and the real-estate boom in the late 2000s. And he developed a measure of long-term stock valuation that many professional investors rely on.

Yet the central message that emerges from three conversations with Prof. Shiller over the past few weeks isn’t a cocksure forecast; it is a deep humility in the face of irreducible uncertainty.

Many analysts have warned lately that Prof. Shiller’s long-term stock-pricing indicator is dangerously high by historical standards.

Known as the “cyclically adjusted price/earnings ratio,” or CAPE, Prof. Shiller’s measure is based on the current market price of the S&P 500-stock index, divided by its average earnings over the past 10 years, both adjusted for inflation. It stands at nearly 26, well above the long-term average of about 16.

If only things were that simple, Prof. Shiller says.

“The market is supposed to estimate the value of earnings,” he explains, “but the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. So the long-term average is “highly psychological,” he says. “You can’t derive what it should be.”

Even though the CAPE measure looks back to 1871, using data that predates the S&P 500, it is unstable. Over the 30 years ending in 1910, CAPE averaged 17; over the next three decades, 12.7; over the 30 years after that, 15.7. For the past three decades it has averaged 23.4.

Today’s level “might be high relative to history,” Prof. Shiller says, “but how do we know that history hasn’t changed?”

So, he says, CAPE “has more probability of predicting actual declines or dramatic increases” when the measure is at an “extreme high or extreme low.” For instance, CAPE exceeded 32 in September 1929, right before the Great Crash, and 44 in December 1999, just before the technology bubble burst. And it sank below 7 in the summer of 1982, on the eve of a 17-year bull market.

Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion. So, he says, he and his wife still have about 50% of their portfolio in stocks.

On Thursday, as the Dow fell more than 300 points, Prof. Shiller told me, “The market has gone up for five years now and has gotten quite high, but I’m not selling yet.” He advises investors to monitor not just the level of the market, but the “stories that people tell” about the market. If a sudden consensus about economic stagnation forms, that could be a dangerous “turning point,” he says.

Based on new research he has done into industry sectors, he says, he is “slightly overweight” in health-care and industrial stocks.

The third edition of Prof. Shiller’s book “Irrational Exuberance,” coming out in February, will feature a chapter on bonds.

Is the bond market, as some investors have suggested, a bubble bound to burst?

“A bubble is a product of feedback from positive price changes that create a ‘new era’ ambience in which people think increasingly that prices will go up forever,” Prof. Shiller says.

Today’s bond market, he adds, “is just the opposite of a new-era ambience.” Instead, the demand for bonds is driven by “an underlying angst” about the slow recovery and pessimism about the future. “That’s not a bubble,” he says.

It also is worth considering where Prof. Shiller gets his knack for seeing what others overlook—the kind of gift that the renowned hedge-fund manager Michael Steinhardt has called “variant perception.”

Prof. Shiller is an unconventional thinker who relishes investigating ideas that other people regard as eccentric or unrewarding. “I don’t fit in so well,” he says, shrugging. “I’m socialized differently somehow.”

Prof. Shiller—and his wife, Ginny, a clinical psychologist—suspect that he has “a touch” of attention deficit hyperactivity disorder. “I’m very distractible, although I can be highly focused on tasks that interest me,” he says.

It is that intensity of thinking that leads to rare big insights—and to the recognition that, as he puts it, “a lot of fundamental problems aren’t really soluble.”

One friend recalls meeting him for lunch in New Haven; afterward, Prof. Shiller offered to give him a lift to the train station. But, the friend recalls, “Bob couldn’t find his car. He couldn’t remember where he had parked it.”

“Bob came into my office one day in the early 2000s,” his colleague, Yale finance professor William Goetzmann, told me. “He said, ‘I think we are in a real-estate bubble.’ I listened to him and said, ‘Hmm, that’s interesting,’ and when he left, I went right back to whatever research I was doing.” Prof. Shiller went on to produce the first serious warnings that the housing market would collapse.

Prof. Shiller says both stories sound right to him.

I reached him by phone earlier this month after he had missed an earlier appointment to speak. “I was awaiting your call,” he said, “but somehow never heard the phone ring.” Later he clarified that he might have left his cellphone in the next room but wasn’t sure.

It isn’t hard to imagine him sitting there, oblivious to the ringing phone and every other sight and sound, lost in contemplation of big ideas.

Creative Capitalism: Gates & Buffett

CreativeCapBook Review:

A noble effort that fails to converge on ideas…

There are basically two teams in this match of ideas, with several participants trying to referee. On one side are the economists by trade, who are very skeptical about non-market criteria in economics. On the other side are the non-economists who believe the art and science of economics needs to be broadened, but are unclear on how this can be accomplished. Notably, I found the most refreshing approach of the many experts participating in the blog offered by perhaps its youngest contributor – the student Kyle Chauvin – who argued how we need to expand the reach of traditional, or profit, capitalism, not only around the world but to the overlooked corners of the developed world as well.

Unfortunately, the two sides never really converge in this debate and I suppose that may be why the conversation has disappeared from public discourse. Both sides accept some common premises that need to be challenged in order to break out of the box we find ourselves in on these issues.

These premises derive from the neoclassical school of economic theory that laid the foundation for general equilibrium theory in macroeconomics. Specifically, actors within the economy are classified according to a loose application of factor analysis, so we have workers, entrepreneurs and small business owners, corporate firms and managers, investors, savers, lenders, borrowers, consumers, and political actors. Then we lump these categories into producers, savers, and investors on one side versus consumers, workers, and borrowers on the other. The consensus seems to settle on the idea that some people produce and so policy should empower this production. Then successful producers can be taxed by political actors, and/or encouraged by philanthropy, to redistribute the wealth to non-producers for reasons that range from compassion to demand stimulus.

Capital accumulation and equity ownership in capitalist enterprise is an essential form of participation in the modern global market economy. Concomitant with ownership is the question of control in governance and risk management as the flip side of profit. But instead of focusing on how wealth is created and distributed through these market structures and institutions, we insist on dividing capital from labor and then try to redistribute the outcomes by political calculus, or by corporate largess. This is industrial age capitalism and such a mode of production will never accomplish what we hope to through creative capitalism. (I do agree with Clive Cook that we need a better term—maybe Inclusive Capitalism or the Singularity, to borrow from Ray Kurzweil.)

The problems that corporate social responsibility (CSR) seeks to address are rooted in the skewed distribution of productive resources across society, widening the gap between the haves and the have-nots. But taxing the haves to give to the have-nots is a self-defeating form of compassion. We should try to adhere to the Chinese proverb about teaching a hungry man to fish so that he eats for a lifetime. This can be put most plainly by asking the following question: If corporations work solely to enrich shareholders, then why aren’t we all shareholders? To widen the economic net even more, why aren’t all enterprise stakeholders shareholders?

Equity participation may also be the most viable way to promote “recognition” as a complement to profit maximization, as stakeholders have a broader range of interests, of which immediate profits is only one. This idea also focuses our attention on the real problem of free societies: agency failures and governance. Market economies depend on a multiplicity of agent-principal relationships in economic enterprises and political institutions. The abuse of these relationships is the mark of cronyism that dominates public attitudes toward “undemocratic” capitalism these days. This is not an easy problem to solve, but suffice to say equity ownership, control, and risk management must be as open, transparent, and competitive as possible. This is the only way to confirm that these relationships are accepted as just.

The only sustainable solution to world poverty and the skewed distribution of resources is the creation of a worldwide, self-sufficient, productive middle class. This is as necessary for democratic politics as it is for economics. For the middle class to grow, it needs access to resources, mostly financial capital and technology these days.

We can point to the history of land homesteading that built the American Midwest, and just recently, the idea floated by Michigan’s governor to promote homesteading in Detroit for foreigners. Society’s resources need to be spread far and wide in order to reap the benefits of innovation and adaptation, while maximizing the utilization of these resources. The financial imperative of capital is to maximize return, but the socioeconomic objective seeks to do so by combining capital with labor. This flies a bit in the face of the efficiency argument that some people are better at managing risk and creating wealth, so specialization of function should favor the risk managers on Wall Street. The problem is that we never know where to find the successful entrepreneurs and job creating small businesses of the future, only those of the past. And Wall St. only considers those who manage to squeeze through the narrow access door.

Without angel capital provided by family relations who merely saved and accumulated their personal wealth, many enterprises would never see the light of day. At the early stages, venture capital money is too costly or unavailable. This story is repeated across the economy, yet today’s concentration of capital in venture firms, hedge funds, private equity, buyout firms, major bank holding companies, etc. narrows capital access to those who already have it. The proliferation of ideas must be forced through this bottleneck, to what end? Better that individuals, families, small group networks, etc. are empowered by policy to accumulate their own capital to put at risk in entrepreneurial ventures. After all, sometimes the idea is not so sexy and may be nothing more than a new restaurant idea or a better mousetrap. In a world where the future is unknown, we can’t lock ourselves into narrow investment models built on the past. Likewise, we should not underestimate the ancillary growth Microsoft seeded by enriching its own shareholders.

The key point, which cannot be overemphasized, is that broad capital accumulation achieves double the impact of other policy options. First, it helps finance ideas, innovation and entrepreneurial risk-taking that will increase labor utilization, spreading the risks and benefits of economic growth. Second, accumulated financial assets, or savings, help mitigate economic risks of unemployment, health, and retirement through self-insurance. This reduces political demands on the state’s safety-nets and the tax and redistributive policies on productive effort that hampers economic growth. Essentially, policies that promote broad-based capital accumulation are a win-win for all citizens of a democratic capitalist society.

How Do You Say QE in German?

cartoon_i

Europe’s politicians want monetary easing without pro-growth reform.

As we can read in this WSJ editorial, fiscal policy reform is no better in Europe than it is here in the US. The result is that the central banks of the world are kicking the can down the road by creating excess liquidity to shore up the global economy. As the US dollar is the world’s reserve currency, the Fed has been able to pursue this strategy at little cost upfront. It has convinced Japan to adopt such credit policies and soon the ECB will be dragged into greater levels of QE as the Euro economy falters. At some point China and Switzerland will be on-board. In fact, these central banks have little choice.

The centripetal forces of global finance are forcing the rest of the world to adopt the credit driven policies of the US. This is also leading to centrifugal forces in national politics that have the potential to create serious conflicts. As long as this policy holds, the benefits will accrue to the US while the risks build. Anybody who holds $ assets will also reap the benefits, meaning the inequality gap between the haves and have-nots will widen.

If the system experiences another serious global shock, nobody really knows what happens then, but it could be the Mother of All Global Depressions, or it could be WWIII. We’d like to think these are very small probabilities of disaster, but it’s seems imprudent to pursue policies that raise these probabilities.

The Draghi Default

You can’t say Mario Draghi isn’t doing his part. The European Central Bank President once again fulfilled the pleas of European politicians Thursday with another round of rate cuts and the promise of more monetary easing to come. Too bad the politicians keep using Mr. Draghi as an excuse to dodge their responsibility to pass pro-growth reforms.

Thus we are getting another round of the Draghi Default, in which monetary policy is supposed to do all the heavy growth lifting for Europe. The central banker obliged by cutting the main lending rate to 0.05% from 0.15%, even though he had said in June the central bank was already at “the zero bound.” The ECB also increased the so-called negative deposit rate, or the rate banks will pay for holding deposits at the central bank, to minus-0.2% from minus-0.1%, in a bid to force more bank lending.

Mr. Draghi’s larger goal is to keep talking down the euro exchange rate against the dollar in a bid to lift inflation in Europe closer to the ECB’s 2% target. With inflation at 0.3% year over year in August, and the U.S. dollar getting stronger on the hope of faster U.S. growth, you can at least make a case for easing on monetary grounds within the ECB’s mandate to maintain stable prices. Mr. Draghi had already talked down the euro to 1.315 from 1.40 to the dollar since May, and on Thursday it fell again to 1.295 after Mr. Draghi’s announcement.

Yet further reductions in interest rates, even into negative territory, aren’t enough to assuage euro-zone politicians. So in his press conference Thursday Mr. Draghi also announced a version of quantitative-easing lite. For political and legal reasons, expanded buying of government debt a la Washington, London and Tokyo is more difficult for the ECB. Mr. Draghi says he’ll instead buy covered bonds and so-called asset-backed securities, or ABS, which are bundles of corporate and household loans.

Unlike U.S. credit markets, only some €300 billion ($390 billion) of ABS are outstanding in Europe at the moment. Mr. Draghi has been trying to expand such a market with the new cheap, medium-term lending program he announced in June, and perhaps the central bank’s cash can stimulate a wider and deeper credit market.

The problem comes from believing that QE is some magic growth elixir. The world’s Keynesians have convinced themselves that the U.S. is now growing faster than Europe simply because the Federal Reserve implemented QE while Europe hasn’t. That overestimates QE’s impact on U.S. growth, which has hardly been gangbusters at a mere 2% average annual rate. But it also underestimates the degree to which European economies are burdened by aging populations, high taxes, regulations on business, and constricted labor markets.Mr. Draghi understands this, which is why he keeps repeating as he did Thursday that Europe needs “ambitious and important” reforms “first and foremost” to return to growth. Yet those reforms never arrive, and now the politicians have another excuse to delay as they wait for an ABS program to start next year. This has already happened once on Mr. Draghi’s watch, when his promise of unlimited sovereign bond purchases in 2012 pushed government bond yields so low so fast that it eased credit-market pressure on governments to reform.

The other danger is that Europe will interpret the ECB’s opening for more fiscal policy stimulus as an excuse for more government spending. Mr. Draghi has hinted at easing the EU’s deficit limits. This would make sense if politicians followed through with pro-growth tax cuts as Spain has. But another burst of government spending won’t spur growth and would only set the euro zone up for more tax-raising austerity later.

Europe’s main economic problem is a political class that doesn’t want to address the structural impediments to growth that have nothing to do with monetary policy. Mr. Draghi is being asked to perform miracles he can’t deliver.

What’s Going On?

pigs

Marvin Gaye asked this question referring to American society in the 1960s. We could ask it again in the 2010s.

This macroeconomic and monetary policy analysis by the Hussman Funds is extremely insightful. Read the full essay here. I include a few relevant excerpts below:

Several factors contribute to the broad sense that something in the economy is not right despite exuberant financial markets and a lower rate of unemployment. In our view, the primary factor is two decades of Fed-encouraged misallocation of capital to speculative uses, coupled with the crash of two bubbles (and we suspect a third on the way). This repeated misallocation of investment resources has contributed to a thinning of our capital base that would not have occurred otherwise. The Fed has repeatedly followed a policy course that sacrifices long-term growth by encouraging speculative malinvestment out of impatience for short-term gain. Sustainable repair will only emerge from undistorted, less immediate, but more efficient capital allocation.

First, we should begin by stopping the harm. Quantitative easing will not help to reverse this process. The dogmatic pursuit of Phillips Curve effects, attempting to lower unemployment with easy money, has done little to materially change employment beyond what is likely to have occurred without such extraordinary intervention, but has contributed to speculative imbalances and an increasingly uneven income distribution. Indeed, Fed policy does violence to the economy by helping to narrow it to what complex systems theorists call a “monoculture.” Nearly every minute of business television is now dominated by the idea that the Federal Reserve is the only thing that matters. Meanwhile, by pursuing a policy that distinctly benefits those enterprises whose primary cost is interest itself, the Fed’s policies have preserved and enhanced too-big-to-fail banks, financial engineering, and speculative international capital flows at the expense of local lending, small and medium-size banks and enterprises, and ultimately, economic diversity.

The always observant Charles Hugh Smith puts it this way: “Diversity and adaptability go together; each is a feature of the other. The Federal Reserve has created an unstable monoculture of an economy. What should have triggered a ‘die off’ of one predatory species – the ‘too big to fail’ mortgage/commercial banks and the Wall Street investment banks – was redistributed to all other participants. In insulating participants from risk, fact-finding, and volatility, you make price discovery and thus stability impossible.”

The Federal Reserve’s prevailing view of the world seems to be that a) QE lowers interest rates, b) lower interest rates stimulate jobs and economic activity, c) the only risk from QE will be at the point when unemployment is low enough to trigger inflation, and d) the Fed can safely encourage years of yield-seeking speculation – of the same sort that produced the worst economic collapse since the Depression – on the belief that this time is different. From the foregoing discussion, it should be clear that this chain of cause and effect is a very mixed bag of fact and fiction.

The economy is starting to take on features of a winner-take-all monoculture that encourages and subsidizes too-big-to-fail banks and large-scale financial speculation at the expense of productive real investment and small-to-medium size enterprises. These are outcomes that our policy makers at the Fed have single-handedly chosen for us in the well-meaning belief that the economy is helped by extraordinary financial distortions.

 

 

 

Central banking and inflation.

inflation

Quoted in WSJ:

From an interview with former Federal Reserve chairman Paul Volcker (Class of 1949) in the Daily Princetonian, May 30:

DP: [D]oes high inflation matter as long as it’s expected?

PV: It sure does, if the market’s stable. . . . The responsibility of the government is to have a stable currency. This kind of stuff that you’re being taught at Princeton disturbs me. Your teachers must be telling you that if you’ve got expected inflation, then everybody adjusts and then it’s OK. Is that what they’re telling you? Where did the question come from?

DP: Okay. Could you talk a little bit about the justification behind the Volcker Rule and the effect you think it’s had on the market?

PV: The rule is that institutions that are protected by the government, implicitly or explicitly, should not be engaged in speculative activities that bear no real relationship to the purposes for which banks are protected. Banks are protected to make loans, they’re protected to keep the payments system stable. They’re protected so you have a stable place to put your money. That’s why banks are protected. They’re not protected to engage in speculative activities which led to risk and jeopardized the banking system. That’s the basic philosophy. I think it’s pretty well-accepted. . . .

DP: Okay. And to get back to the central banking a little bit, given the trade-off between inflation and unemployment—

PV: I don’t believe that. That’s my answer to that question. That is a scenario and a delusion, which economists have gotten Nobel Prizes twenty years ago to disprove.

%d bloggers like this: